This second installment continues to review the strategies that are used by planners to assist their clients in conserving the wealth they have accumulated in order to transfer it to the next generation(s) at the least tax cost (part one appeared in the June 2006 issue of Investment Advisor). The concepts and techniques discussed in Part I were the equalization of assets, the qualified personal residence trust (QPRT), the grantor retained annuity trust (GRAT), and the intentionally defective grantor trust (DGT). Included in the foregoing discussions was the importance of using the applicable federal rates (AFR), in determining discounts to be applied to the market values of transferred assets. In this column we will explore the use of various special types of charitable trusts and the family limited partnership concepts. Exploration of additional vehicles is available at www. investmentadvisor.com.
Charitable Annuity Trusts
There are two basic types of charitable annuity trusts–the charitable remainder trust and the charitable lead trust.
A charitable remainder trust (CRT) may be established during the grantor’s lifetime or pursuant to a will. It requires a fixed annuity percentage to be paid no less frequently than annually to a non-charitable beneficiary for a specified term (maximum 20 years). At the conclusion of the term of the trust, the designated charity will receive the remaining assets in the trust. There are two types of charitable remainder trusts:
A Charitable Remainder Annuity Trust (CRAT) requires a specific sum, calculated on the fair market value at the start of the trust, to be remitted at least annually to a beneficiary other than the named charity.
The Charitable Remainder Unitrust (CRUT) pays a variable amount to the non-charitable beneficiary. This payment varies because it is computed by applying a fixed percentage each year to the value of the trust’s assets on a specified date (e.g., 6% of the value of the trust each January 1st).
If properly structured, the CRT can be established so that on the death of the primary non-charitable beneficiary the income payments can be directed to another individual (e.g. surviving spouse) before ultimately getting to the charity. The amount going to the charity is not subject to estate tax because of the estate tax charitable deduction. If the successor beneficiary is the surviving spouse the estate tax marital deduction will apply. If, however, the secondary beneficiary is other than the surviving spouse, the annuity or unitrust payment will be subject to estate tax computed on the actuarial value of the amount to be paid to this individual.
From an income tax perspective, a CRT is a tax-exempt entity. Therefore there is no tax on any capital gains it may incur. If the donor, who can also act as the grantor, has highly appreciated property that does not produce adequate income, it may be the ideal asset to make the basis of the CRT. By having the CRT sell this property it can be converted from a highly valued, low income-producing asset into cash which can then be invested to generate a higher rate of return. Since the CRT is a tax-exempt entity, all of the foregoing is done without the loss of principal due to payment of capital gains tax. The capital gain is reported by the annuitant based upon the annual annuity paid from the trust, reduced by any ordinary trust income the individual would report. This kind of planning can backfire in that the larger periodic payments going back to the grantor may cause an increase in his estate–the opposite of what was intended. However, this negative effect can be offset by having the donor’s beneficiaries own insurance policies on the grantor’s life which would result in the proceeds coming directly to them without being part of the grantor’s estate.